Funding Fun House

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The news that many corporate pension plans are in trouble, at least on paper, comes as no surprise. After three years of declining stock markets, many large plans cannot help but find themselves underfunded. That such shortfalls have appeared for the first time since the early 1990s and to a degree not seen in a couple of decades merely reflects the longevity and extent of the dearly departed bull market.

After years of getting a bottom-line boost from pension gains, companies are now experiencing pension losses, which show up in a variety of forms, including hits to earnings, cash flow, and equity, depending on the particulars of the plan and complex accounting rules. And though most companies’ shortfalls will not pose immediate liquidity concerns, they are often too large for investors to ignore. For instance, Ford Motor Corp. will spend $1 billion in the next two years to make up a pension shortfall that doubled last year to more than $6 billion. Honeywell may need to contribute $900 million to its plan after assets deteriorated over the past year. And AMR Corp. could face a charge against shareholder equity of more than $1 billion this year to cover its minimum liability.

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Isolated cases? Hardly. A recent report by Credit Suisse First Boston (CSFB) estimates that the aggregate effect on earnings from pension plans for the S&P 500 swung from a gain of $7 billion in 2001 to a negative $1 billion in 2002. The investment bank expects the S&P 500 to report net pension expenses of $15 billion in 2003. Another firm, Watson Wyatt Worldwide, says the real pain isn’t going to be felt until 2004 (barring a full market recovery), since many companies are able to defer cash contributions for a year.

Much Leeway

The real question is, why are the negative effects of pension plans just now starting to make their way onto the corporate radar screen, even though the plans have performed miserably for the past three years? Part of the answer lies in the fact that gains in the late 1990s were so large that many plans became overfunded, and the positive effect this produced only recently, albeit abruptly, disappeared.

But the real reason dismal performance is just now starting to be reflected in corporate financial results is that pension funding and accounting rules allow companies considerable leeway in making contributions and reporting results. For starters, contributions may be delayed for more than a year and a half after plans cease to be fully funded, and, depending on circumstances, the contribution holiday may be extended even longer. What’s more, the accounting — mostly contained in FAS 87 — allows companies to use investment-return and interest-rate assumptions that bear little relation to actual investment results. And since pension details are disclosed only once a year in footnotes, plan performance often escapes notice.

To be sure, headlines proclaiming a pension crisis may be overblown. In fact, underfunding needn’t create immediate problems, since federal law allows those companies whose plans are 80 to 90 percent funded to avoid the accelerated contribution requirements if the plans were 90 percent or more funded for two consecutive years out of the past three. Furthermore, plans that were 100 percent funded in the previous year are permitted to delay the current-year contribution up to 81/2 months after the year ends. In addition, companies that contributed more than the minimum in prior years may have developed a credit against current required contributions. “Many companies will be able to delay cash contributions until 2004,” says Ethan Kra, chief actuary of Mercer HR Consulting.

Still, if losses continue, companies will be forced to make two years’ worth of cash contributions at the same time. Furthermore, complaints are growing that pension accounting has allowed companies to delay recognition of poor investment results. According to a recent study by actuarial firm Milliman USA, 50 of the largest U.S. companies counted roughly $54 billion of pension fund gains as profits last year, when they actually lost almost $36 billion. “If you used the same accounting for the operations side that is used on pension funds, you would be put in jail,” asserts Kra.

Mild Deflation

Such complaints are now gaining currency, with heavyweights from Warren Buffett to Sen. Tom Harkin (D-Iowa) weighing in. The chief criticism is that investment-return assumptions are too high and inflate earnings or hide losses. The average company uses a rate of 9.2 percent, according to the CSFB report. Buffett’s company, Berkshire Hathaway, uses a return of only 6.5 percent.

But it’s pressure like the proposal from California state controller Kathleen Connell that really gets the attention of finance executives. “[The inflated assumptions are] an accounting gimmick that needs to be cleansed out,” she says. Connell has called on the state’s two giant public pension plans, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, to stop investing in companies that use overly optimistic fund projections, and she says they are now considering the return rates in their investment decisions.

David Zion, an analyst at CSFB, says the pressure to be conservative is likely to have a greater impact as companies review their assumptions this year. “I expect that they will come down about 50 to 100 basis points at many companies,” he says. The move will be costly. CSFB estimates that a mere 50 basis-point reduction will result in an aggregate increase in pension costs of $5 billion for the S&P 500.

IBM, for instance, announced during an October conference call that the IT giant would reduce its expected rate of return from 9.5 percent in 2002 to between 8 percent and 8.5 percent this year. “We believe that this will affect the income statement by roughly $700 million next year,” said CFO John Joyce during the call.

While reality checks like IBM’s will help, many analysts contend that more-fundamental reform of the pension accounting system is needed. “The current accounting can be misleading because of the smoothing methods,” says Zion. “What investors want to see is the economic reality of the pension plan reflected on the financial statements.”

To that end, Zion proposes marking pension plan gains and losses at fair market value rather than using assumptions and then amortizing the difference over several years. And while he admits it would create wild swings in earnings and make the bottom line less useful, he thinks it would be better than the current system. “Volatility is not necessarily a bad thing, unless it’s hidden,” he cautions. At the very least, Zion argues that more pension information needs to be disclosed. He thinks a company’s pension funding status should be on its balance sheet on a net basis along with more information on the plan’s asset allocation. Zion also wants to see the effect of pension losses and gains on earnings isolated from operating income. “In most instances you don’t know where it goes,” he says. “It could hit any line where the company puts labor costs.”

Zion is not alone in his call for clearer accounting. Last summer, S&P released a new measure, known as core earnings, that removes pension gains and expenses from operating income. “It’s almost always a gain because you get to set the estimated return,” says David Blitzer, managing director and chairman of S&P’s core earnings committee. “We figure it out and then back it out of earnings.” S&P then adds back interest and service costs that companies pay on their plans, which the agency considers part of the cost of employee compensation. “We think this is the right way to do it,” says Blitzer. That doesn’t mean he wouldn’t also like to see accounting itself separate the effects of a pension plan from company results. “It has nothing to do with the way the business runs,” he says.

Mercer’s Kra believes the current setup prevents many plan sponsors from fully understanding the risks to which the plans expose their companies. “If the Dow were to close at 7,000 for a couple of years in a row, you would see many companies that are pulled under by their pension plans,” he says. The United Kingdom has modified its accounting rules to put assets and liabilities on the balance sheet and mark them to market, and Kra believes it’s quite possible that this could become the system here as well, thanks to the convergence project between the Financial Accounting Standards Board and the International Accounting Standards Board. “I would be shocked if the system we have today were still in place in six months,” he says.

The issue currently isn’t on FASB’s agenda. But the board recently decided to survey analysts and investors to see whether it should be added, and chairman Robert Herz recently told Reuters that he personally dislikes the U.S. approach.

Bad-News Bearers

Granted, companies whose pensions are in the worst shape have shed more light on their accounting. GM, Ford, and IBM have all recently held conference calls with investors to talk expressly about the status of their pension plans, and Ryder Systems posted a white paper on its Web site in November that outlined its expectations for its pension plan. “Companies are trying to give as much information on their pension plans as possible,” says Art Garcia, controller of Ryder Systems Inc. While Garcia says that he does not favor changing the accounting for pensions, he does advocate more disclosure. Whether finance executives will continue to disclose more when things improve, though, and pension plan accounting is helping the bottom line, remains to be seen.

Kevin Wagner, a consulting actuary at Watson Wyatt, thinks better disclosure for pension plans is here to stay. “Companies have found it very beneficial to make the financial details of pension plans more transparent to investors,” he says.

Not everyone is so confident. S&P’s Blitzer expects many companies to wait until year’s end to reveal problems. Yet he warns that in the current environment, fewer companies will find they can hide behind complex accounting. “If it’s material,” says Blitzer, “you’d better own up to it soon.”